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Before the recent spike in Treasury yields, investors were in
widespread agreement that long-term bonds, especially long-term
Treasuries, would be particularly hard-hit in a rising-rate
environment.

Sure enough, long-term Treasuries have gotten socked during the
past few months as yields have jumped up. The typical long-term
Treasury fund in Morningstar's database dropped about 13% from
the time yields began rising in early May through July 5, when
yields topped out (at least for now).

Yet rising-rate pain hasn't been limited to long-term
Treasuries. A host of disparate categories, from emerging
markets to REITs, have experienced large losses recently.

Does that mean you should scrub your portfolio of securities you
perceive to be rate-sensitive? Not necessarily, as rates can turn
on a dime. Just during the past week, Treasury yields have
dropped down again, and the bonds have rallied as Federal Reserve
chairman Ben Bernanke aimed to reassure investors that the Fed
won't be tapering its bond-buying program imminently. Moreover,
there's no telling that the crop of investments that fared poorly
in the recent rate uptick will necessarily struggle in the next
one. Additional factors--from slowing economic growth to an
appreciating dollar--might have played as much a role in their
recent troubles as rising rates.

But if you found your portfolio rattled more than you might have
expected amid the market's so-called recent taper tantrum, that
should serve as an impetus to check on what performed poorly and
why. Here's an overview of some of the securities that were
hardest-hit during the recent yield spike, along with why they
struggled. In certain categories, the recent performance
struggles were driven by additional factors--not just rate
increases--so these categories' slumps aren't necessarily a
harbinger of bad performance the next time rates rise.

Treasury Inflation-Protected
SecuritiesLoss from May 1 to July
5: -7.86%

Why They Dropped: TIPS have suffered
from a bad convergence. The asset class has always been quite
rate-sensitive, and coming into the recent rate spike, most TIPS
funds sported the bad combination of fairly long durations [a
measure of interest-rate sensitivity] of 6 to 8 years or more and
meager yields. But perhaps an even bigger strike against TIPS has
been the fact that inflation is currently quite tame, in large
part because of slowing economic growth overseas. That, in turn,
has reduced demand for securities with built-in inflation
protection, damping TIPS' prices.

Takeaway: TIPS remain the most direct
way to hedge against inflation, and therefore they can serve a
valuable role in a portfolio. But their recent weakness
underscores their vulnerabilities in certain environments and the
importance of having an appropriate time horizon for owning them.
Because their rate sensitivity is likely here to stay, a core
TIPS fund like
Harbor Real Return(HARRX)
or
Vanguard Inflation-Protected Securities
(VIPSX)
is best used in the intermediate-term portion of a
portfolio--that is, for time horizons of at least five years.
(Vanguard Short-Term Inflation-Protected Securities
(VTIPX),
a new Vanguard fund, may be appropriate for those in need of a
shorter-term inflation hedge.) It's also worth noting that
working investors who are earning periodic cost-of-living
adjustments need relatively less inflation protection than
retired investors who are spending their portfolios. But some
retirees may not need substantial TIPS exposure, particularly if
Social Security and/or an inflation-adjusted pension or annuity
is fulfilling a higher share of their income needs.

Emerging-Markets BondsLoss from May 1 to July 5: -9.58%

Why They Dropped: Emerging-markets
bonds have suffered some of the steepest losses during the recent
rate increase, with emerging-markets bonds denominated in local
currencies faring worst of all. (Diversified funds such as
PIMCO
Total Return
(PTTRX)
have also struggled because of their emerging-markets stakes, as
discussed in this
video.) A few key factors are behind the recent swoon. First,
rising Treasury yields make risk-taking in emerging-markets bonds
seem less attractive. Why take on the extra risk in an
emerging-markets bond for a yield that's only a few percentage
points higher than what you can get in Treasuries or high-quality
U.S. corporate bonds? Moreover, key emerging-markets
currencies--including the Indian rupee--have plunged relative to
the dollar and in the process have dragged down bonds denominated
in those currencies.

Takeaway: Investors had arguably become
complacent about the risks in emerging markets and other risky
bond types--including the locally denominated debt--enticed by
their higher yields. The recent tremors underscore the bonds'
vulnerabilities in certain environments. It's not necessarily
time to jettison the bonds--in fact, some experts say that the
rout has created opportunities. But if you have an
emerging-markets bond fund in your portfolio, it's worth checking
up on its strategy and positioning. The recent performance
weakness also underscores that non-dollar-denominated bonds
introduce a wild card--foreign currency fluctuations--into the
portion of a portfolio that most investors look to for ballast.
Morningstar's Lifetime Allocation Indexes
call for just a small share of a portfolio to be staked in
foreign bonds (not just emerging markets). Moreover, the indexes'
weightings in foreign stocks and bonds taper off as an investor
grows closer to retirement.

Emerging-Markets EquitiesLoss
from May 1 to July 5: -10.09%

Why They Dropped: Like emerging-markets
bonds, emerging-markets stocks have suffered for a variety of
reasons--not just rising rates. Slowing growth in key markets,
especially China and India, has depressed share prices in a
number of emerging markets. Appreciation in the dollar versus
many foreign currencies has also had a hand in the securities'
slump.

Takeaway: Although emerging markets
have fallen because of concerns about slowing growth, cheap
valuations tend to be a better predictor of market performance
than gross domestic product growth, as discussed in this
Vanguard paper. That means periods of macroeconomic
pessimism, like what emerging markets are experiencing right now,
can spell buying opportunities. Delegating your emerging-markets
stake to a value-minded foreign-stock manager with a history of
playing emerging markets to good effect is one way to approach
the situation;
Dodge & Cox International Stock
(DODFX)
is a prominent example.

UtilitiesLoss from May 1 to
July 5: -6.16%

Why They Dropped: As bond yields have
shriveled during the past several years, investors have been
flocking to dividend-rich stocks such as utilities. In many
cases, doing so has enabled them to pick up commensurate or even
higher yields than they could earn in bonds, along with some
growth potential to boot. Like other income-producing stocks,
however, utilities often suffer by comparison when bond yields
rise. Additionally, utilities enjoyed a stellar first quarter and
were priced for perfection coming into the recent rate increase,
according to
Morningstar analysts' price/fair value ratios.

Takeaway: Despite the recent
performance weakness, the average utilities stock in
Morningstar's equity analysts' coverage universe is about 5%
overvalued currently, even though the sector got cheaper back in
late June. It's also worth remembering that utilities take up
only a small share of the total U.S. market--roughly 3%, as of
last count. Use Morningstar's Instant
X-Ray tool to check your weighting in the sector and be
mindful of the risks if your stake in the sector is substantially
higher than that. In addition to so-so valuations, utilities are
apt to remain rate-sensitive for the foreseeable future.

REITsLoss from May 1 to July
5: -7.37%

Why They Dropped: REITs' recent decline
has a lot in common with the story on utilities. Although REIT
yields are typically higher than what you'd earn on a
high-quality bond, they suffer when bond yields rise. Moreover,
REIT prices looked precarious coming into the sell-off; during
the past five years, stocks in the sector have looked especially
overvalued to Morningstar equity analysts while yields have
declined. Global real estate securities have faced the double
whammy of rising U.S. bond yields and a rising dollar, with the
average fund in the group dropping 9.4% from early May through
early July.

Takeaway: Although the average REIT
looked cheaper to Morningstar's equity analyst team a few weeks
ago, it's been off to the races for the sector lately. That means
that the average stock in our coverage universe is now trading
above its fair value. Here again, it pays to check on your
exposure relative to a total U.S. market index, which currently
includes a 3.6% allocation to REITs. If you have a small-value
fund in your portfolio, it's a good bet you already have plenty
of REIT exposure; the average fund in the group stakes 7% of its
assets in the sector.